Public pensions at the state and local level are underfunded by more than $1 trillion; in many cities, pension obligations will soon consume a quarter or more of the annual budget — money that will be unavailable for parks, libraries, street maintenance and public safety.

Part of the problem is that pension funds need significant new financing to cover the growing number of retirees. But the real issue is the lack of incentive to improve pension performance. What we need, then, is a federal program that combines stimulus with serious fund reform.

The pension-fund crisis is rooted in the intersection of excessive optimism by fund managers and the funds’ influence on the political process. Funds regularly overestimate their future performance: Calpers, California’s giant state pension fund, assumed, and still assumes, it will earn 7.75 percent annually on its investments; in fact, its returns over the last decade were, on average, less than half of that.

But Calpers wasn’t left holding the bag. Instead, it was able to force the state to increase its contribution to the fund; indeed, the state’s 2010 share will be about five times what it was forecast to be in 1999.

The Calpers case is hardly unique; the same story has been repeated across the country. Often, though, pension funds — including, until recently, New Jersey’s — have been able to hide their liabilities behind clever, nonstandard accounting methods.

This charade can’t last. Eventually debt-heavy governments will begin to default, which will disrupt the municipal bond market by blocking access to new capital for even the most credit-worthy public institutions. Ultimately, Washington may have to add local governments to the list of institutions it must bail out, next to banks and car companies.

But given how poorly pension funds have managed themselves, the federal government can’t simply hand out checks. Instead, borrowing a page from the Education Department’s Race for the Top initiative, which provides money to states that propose significant reforms for their public school systems, it should strike a grand bargain with city and state pension funds: in exchange for capping their liabilities and adopting better management practices, they could cover their costs through tax-free, federally guaranteed securities.

Here’s how it would work. A city, county or state facing insurmountable pension costs would appeal to the Department of Treasury for relief. As a first step, it would have to adopt standard accounting practices to accurately portray its current and expected financial health, including realistic projections of its investment returns and the discount rates on its debt.

Second, the applicant would have to take action to assure it can meet the debt service on its bonds, including placing a permanent cap on its pension liabilities. This means raising the retirement age, increasing employee contributions and preventing employees from manipulating their salaries in the last years before retirement to increase their pensions; it would also mean restructuring the fund’s health-care spending, which has been a significant drain.

Finally, the fund would have to move all new employees to 401(k) retirement plans, which have fixed employer contributions and therefore reduce future taxpayer liabilities.

In exchange, the Treasury would authorize the fund to issue tax-free “pension protection” bonds which, for a fee, would be guaranteed by the federal government. Proceeds from the bond sales would cover its liabilities, providing a quick resolution to the underfunding crisis.

Today’s bond market is the perfect environment in which to introduce a new security like pension-protection bonds. With their tax-free status, a federal guarantee, accurate accounting and the promise of a permanent fix, these securities might even be priced lower than Treasury bills, which are yielding 3.8 percent for 30-year bonds.

A Race to the Top for public pensions would offer something for everyone. The federal government would get a voluntary, low-cost way to avoid paying trillions down the road. Cities and states could cap their pension liabilities and close their funding gaps with inexpensive long-term debt, allowing them to get back to the business of providing needed services. And public-employee unions would get a federal guarantee behind their increasingly uncertain pension benefits.

The Obama administration’s Race to the Top initiative has been a bold experiment in education reform. The White House and Congress now have the opportunity to apply the same idea to the public-pension crisis. Otherwise, chaos is just around the corner for our cities, counties and states.

Although these measures sound reasonable, I am afraid that they will do little to stop the ongoing hemorrhaging at pension funds and I also have my reservations over the proposed fixes. First, I am against any plan which forces workers off defined-benefit plan to a defined contribution plan. In this wolf market, dominated by prop traders, large hedge funds and HFT algorithms, this will just lead the sheep to their slaughter. Sure, some individuals will do well, but most will end up suffering from pension poverty.

Second, adopting "standard accounting methods" might sound reasonable, but mark-to-market typically exaggerates losses and gains in private markets (private equity, real estate, and infrastructure). If you adopt strict accounting rules, you will end up penalizing funds, forcing them to sell assets at the worst possible time.

Third, although pension-protection bonds sound appealing, you need a lot more transparency to accurately assess their true value. Who will rate these bonds? Will we know exactly what these pension funds are investing in, including internal derivative strategies and what all their external managers are investing in? I can just imagine the reaction of hedge funds and private equity funds when the rating agencies come knocking on their door. Moreoever, I am not at all convinced that the environment in the bond market is perfect for pension-protection bonds. The biggest risk pensions face is deflation, which is why the Fed will do whatever it takes to reflate risk assets and introduce mild inflation in the economic system.

Finally, there are no easy fixes. I agree with the authors that investment projections are too rosy, and that retirement age and contribution rates have to be raised, but we need to start thinking more carefully about how we will address the ongoing pension crisis by adopting long-term measures which benefit all of society. These measures must include adopting the highest governance standards and they must include meaningful financial reforms which protect all investors from the vagaries of Casino Capitalism.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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